Income has historically been one of the best-performing investment strategies. The average annualised return of dividend-paying stocks in the S&P 500 between 1973 and 2024 was 9.2%, compared with 4.3% for non-dividend-paying stocks, according to a study by Ned Davis Research. What’s more, dividend payers were less volatile and offered more protection during market downturns. In 2022, when the S&P 500 declined by more than 18%, dividend-paying stocks in the index fell by 11.1%, while non-dividend payers experienced a 38.7% loss. In the global financial crisis of 2007-2009, S&P 500 earnings per share plummeted by 92% while dividends fell by only 6%.
A wealth of other studies come to a similar conclusion. One explanation for this is superior financial health. Companies with the best dividend records tend to have robust balance sheets, strong profit margins and substantial economies of scale, as well as competitive advantages. Cash that isn’t distributed is reinvested, used to reduce debt or spent on buying back stock.
Avoid the income trap
However, investors need to be careful what lessons they take from this. Companies outperform not because they pay a dividend, but because they are financially responsible enough to maintain that dividend. Do not confuse yield with value or quality. A company that offers a high dividend yield is not necessarily cheap or a good business. In fact, the very highest-yielding stocks often underperform the market over time – their dividends are high because they are unsustainable. Some research suggests splitting the market into five groups by yield and focusing on the second-highest yielding group instead.
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Income investors and fund managers chasing yield often fall into these kinds of traps. Active fund managers with an income mandate are particularly vulnerable, since they must keep pace with the rest of the industry.
The FTSE 100 currently yields roughly 4%, and many UK equity income managers will use this as a benchmark for their portfolio. That means they could be forced to deploy capital in stocks that are not necessarily of the best quality but offer the highest yields, in order to maintain the yield from their fund.
Balance income and growth
Instead of relying solely on the dividend yield, investors should consider funds that take into account the total shareholder return, also known as the total shareholder yield. Companies that return cash to shareholders through other methods – such as stock buybacks or debt repayment – have more flexibility than firms trying to chase fixed dividend targets.
Management can switch off buybacks at any point, and often pause paying down many types of debt if they wish. Reneging on dividend expectations is significantly more risky. There’s a lengthy list of CEOs who have had to step down after U-turning on a dividend commitment.
Investors should also look at growth. Dividends are powerful, but a company’s earnings growth ultimately dictates how much cash it can return to investors. A fund that focuses on growth rather than income could generate better long-term returns.
You can still draw a regular income from a fund that achieves strong capital gains by selling, say, 4% of your holding every year. Since the top rate of capital gains tax is currently 28%, compared with 39.4% for dividends, there may be a tax benefit to this approach as well, if your fund is held outside a tax wrapper such as an individual savings account (ISA).
JPMorgan Global Growth and Income (LSE: JGGI) is one such fund we like. Passive investors might look at an exchange-traded fund (ETF) such as Fidelity Global Quality Income ETF (LSE: FGQD).
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